Without a third round of the ECB's long-term refinancing operation, Italian banks will deleverage by up to €444 billion over the next two years - triggering regional contagion if, as is likely, sovereign spreads jump.
In a world bereft of a third round of the European Central Banks (ECB) long-term refinancing operation (LTRO), massive deleveraging of Italian banks will kick in, triggering a dangerous jump in Italian sovereign bond yields deepening the eurozone crisis further.
Given the strong correlation between Italian and peripheral European sovereign-bond spreads, contagion from falling Italian bond prices will felt across the region. Its all down to the umbilical cord between the Italian sovereign and its domestic banks.
For example, according to Société Générale, some 96% of moves in the share prices of Italian banks this year can be explained by shifts in the sovereign yield curve. Whats more, of the 267 billion Italian banks received in the first and second rounds of the LTRO, 65 billion was used to purchase Italian sovereign debt, 4 billion financed hybrid debt liabilities, while 130 billion was ring-fenced to cover maturing wholesale and retail bonds leaving Italian lenders with 68 billion of cash to play with.
And yet there is a projected 228 billion of Italian sovereign bond issuance between May and the end of this year. In this context, the LTRO is likely to be largely ineffective in encouraging Italian lenders to postpone deleveraging, with SocGén analysts predicting banks will cut lending by 148-444 billion during the next two years, equivalent to up to 26% of all private sector loans.
To add fuel to the fire, in May, Moodys downgraded 26 Italian banks, citing earnings pressure and restricted market-funding access. The ratings agencys downward revision of the countrys banking system saw UniCredits long-term debt rating fall by one notch to A3 and Intesa Sanpaolos rating cut to A3 from A2 in addition to 24 downgrades, principally mid-cap financials.
The average un-weighted deposit rating (Ba1) for Italian banks and the average stand-alone credit assessment (Ba2) are now at the lower end of the ratings spectrum compared with other large western European banking systems.
This combination of banks funding risks no doubt triggering a further contraction in economic activity and reduced domestic firepower to snap up Italian sovereign bonds is toxic and suggests market attention might soon turn to Italy, alongside Spain and Greece.
However, in the event of LTRO 3, the pace of Italian bank deleveraging will slow as ECB cash will boost the industrys funding capacity while providing a stronger technical bid for Italian sovereign spreads. In short, Italy is in need of far far more ammunition, just like its troubled eurozone peers Spain, Portugal and Greece.